Pick a Lock

By Ted Howard and Julie Zawacki-Lucci

Interest-rate uncertainty should have treasurers thinking about hedging rates before issuing debt. 

It’s been an article of faith since the financial crisis that companies can lock in low rates at their leisure when issuing debt, not worrying too much about rates suddenly rising.

And that lack of worry has propelled worldwide investment-grade nonfinancial corporate issuance to a record $1.38 trillion in the first nine months of 2015, according to data from Dealogic. US investment-grade MNCs issuance hit $570.4bn, also a record for the period. And companies issuing for acquisition purposes also recorded a new high of $277bn.

However, fears are beginning to creep in, which may account for a near-three week drought in corporate debt issuance in August and September, which was reportedly the longest drought in 20 years. So with the US Federal Reserve poised to raise rates this year and global markets on edge waiting to see what happens in China, relying on rates to stay put while you contemplate a bond issue isn’t a good bet. Even a brief window of time can leave companies exposed to rate swings, and even a basis point uptick can run into the hundreds of thousands of dollars.

The good news is that there are tools treasurers can use to help offset the risk. With so much uncertainty swirling around the market, many companies are considering pre-issuance hedging to mitigate risk and protect against the impact of an increase in rates if a fixed-rate, long-term debt issue is planned for a specific time frame. The time frame for using these tools is fairly wide, depending on your own time schedule. In fact, they can be used at any time prior to final pricing of the debt. This could actually be months prior to intraday, depending on your risk appetite and corporate culture for embracing (or not) such strategies.

Locks of love

There are three major tools that can be used when considering pre-issuance hedging: Treasury Locks, Treasury Caps and Treasury Collars.

Treasury Locks (“T-locks”) hedge the underlying Treasury yield by locking in the forward rate of a Treasury security (either specific or interpolated) to a future date. The difference between the locked-in price and the market rate at time of issue is cash settled at execution of the debt issue. T-locks are well suited for risk-adverse companies looking for a more “vanilla” means of locking in issuance rates.

Treasury Caps provide a ceiling to protect against rising rates; however, they also allow the issuer to keep the benefit of potential rate decreases. Caps are similar to options, so this vehicle requires a premium, which is often a difficult sell internally. Further, when it comes to corporate culture, other departments are usually more comfortable with caps if they are used to more sophisticated hedging strategies and accounting for options.

Treasury Collars combine buying a Treasury cap with selling a Treasury floor and protect against rising rates within a targeted range of a ceiling and a floor. The floor reduces the cost of the option (hopefully to a zero cost structure); however, users lose upside if rates drop below this level. Again, obtaining the internal approval necessary for execution may be easier for those companies accustomed to more sophisticated hedging programs and strategies.

Do the Proper prep

As mentioned, if and when treasury makes the decision to hedge, there will likely be the need to sell it to management due to cost and specific accounting required. Have the structure and possibility to act approved in advance (with appropriate notional and tenor limits) so that when the market moves, you are prepared and able to act. Since the market often moves faster than the necessary steps needed for board/CFO approval, start thinking about and preparing the following:

• The amount to hedge and desired tenor. Note: a portion of the full issue amount (a half to a third) will provide a layer of protection yet sense of relief if rates decrease.
• Calculate cost estimates (both actual and opportunity) and/or model impact to capital structure.
• Consider alternatives. Quantify the impact of a rate swing with or without hedges in place, what various hedge strategies would look like and/or examine other [possibly more complex] hedging vehicles such as forward starting swaps and swaptions.
• Consider your “wallet” and the desired split (if any) amongst bank group.

As of the last employment report, which showed a marked slowdown in hiring for September, many market experts see the odds shrinking that the Federal Reserve will raise rates this year. Fed Chairman Janet Yellen, however, still seems adamant that the Fed will get started and hike rates 25 basis points. Nonetheless, global liquidation of Treasury portfolios (namely China) could get ahead of the Fed’s plans.